Higher returns don’t matter for the short term:
They need time to work their magic
There’s more than one reason behind the old investment message that goes like this: If you need your money in just a few years invest your savings conservatively, but if you have a longer horizon take more risk.
The most commonly given reason is that, while riskier investments like shares or property produce higher average returns over the long term, there’s too big a chance that you will lose money or gain little over a short period.
With shares, for instance, there’s about a 1 in 3 chance of losing money over a single year, I in 5 over three years, and 1 in 9 over five years.
Over ten years, though, the chance is only 1 in 76, and by 15 years it is virtually nil.
However, there’s also another reason to be conservative in the short term but riskier in the long term: The higher return on higher-risk investments doesn’t make much difference over short periods.
Let’s say shares or property earn 8 per cent a year after tax, compared with 4 per cent on term deposits.
We’ll assume that you invest $200 a month. (If you invest $100 a month, halve all the totals; for $400 a month, double the totals. For other numbers, use the regular saving calculator on www.sorted.org.nz)
Over a single year, at 4 per cent you will accumulate about $2,440. At 8 per cent, it will be $2,490 — only $50 more.
Over five years, at 4 per cent it will be $13,200; at 8 per cent, $14,600. That’s still not a huge difference, given that you have to take more risk to get 8 per cent.
When we look at long periods, however, the opposite is true. A higher return makes a big difference — and the longer the period, the bigger the difference.
Over ten years, at 4 per cent your savings will grow to $29,300; at 8 per cent, $36,000.
And over 20 years, at 4 per cent it will be $72,800; at 8 per cent, $113,800.
Young people who save $200 a month for 40 years will see their savings grow to $232,200 at 4 per cent, but $644,200 at 8 per cent. That’s approaching three times as much.
Clearly, as long as you can promise yourself you won’t bail out when the markets do badly for a while, it’s better to put your long-term savings in shares or property.
Two notes to add to this:
- In all these examples we assume you reinvest your interest or dividends. If you don’t, growth is much slower.
In New Zealand shares, for instance, dividends make up about half the return. While total growth — dividends plus capital growth — might average 8 per cent, if you spend the dividends rather than reinvesting them, the growth will perhaps average about 4 per cent.
The numbers above show how much difference that makes over long periods.
- While riskier Investment doesn’t make much difference over a single year if the return is 8 per cent, what if it’s more than 20 per cent, as has happened recently in both the property and share markets?
In such years, riskier investment certainly pays off. But don’t forget the years when returns are negative.
At the beginning of any 12-month period, nobody knows which way a share or property market will move.
Our best guess is the long-term average, of around 8 per cent. Unless you’re a gambler, you’re wise to have a few years in hand over which that average can emerge.
Mary Holm is a freelance journalist, a director of Financial Services Complaints Ltd (FSCL), a seminar presenter and a bestselling author on personal finance. From 2011 to 2019 she was a founding director of the Financial Markets Authority. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary’s advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it.